No Room for Error: A Misstep in Creating an Alternative to Libor Could Be Costly to Investors

Summary

Banks have voluntarily agreed to sustain Libor (London Interbank Offered Rate) until the end of 2021, but plans are not yet concrete for an alternative benchmark.

Given the considerable use of Libor in determining interest payments for securities and derivatives globally, we expect banks will voluntarily administer the benchmark until an alternative is firmly in place.

It is possible, however, that at some point in the future banks elect not to continue reporting Libor. Regulators and industry participants should be prepared for all plausible scenarios.

PIMCO believes that a transition to another benchmark should be carefully managed and occur only when critical elements are in place, including sufficient liquidity in the alternative. Our greatest concern is that a transition that is not well-scripted threatens to favor certain market participants over others.

The clock is ticking on the future of Libor, a benchmark interest rate that underpins trillions of dollars in securities, loans and derivatives around the world.

Andrew Bailey, chief executive of the Financial Conduct Authority (FCA) in the UK, started the clock with his 27 July speech, “The future of Libor,” stating there is voluntary agreement among banks to continue reporting Libor until the end of 2021. Although this should give ample time to prepare for the possible termination of Libor, there are currently no concrete plans for an alternative.

In our view, due to the extensive use of Libor, it is likely that the banking community will continue to voluntarily support and publish a Libor rate for many years. Still, many questions remain, and a misstep could have substantial consequences for investors globally. We strongly argue that a viable alternative needs to be entrenched before Libor is phased out, and that investors should consider there is a marginal risk that Libor ceases abruptly and unexpectedly.

Libor today

Libor represents the average interest rate that a bank would be charged by other banks for an unsecured loan over a specified term in a specific currency. It is used in determining interest payments for over $350 trillion in derivatives, futures, corporate bonds, mortgages and other financial products, according to ICE Benchmark Administration, Libor’s current administrator.

The FCA’s recent announcement about Libor reporting arose in the context of ongoing concerns that banks will withdraw as contributors, that the rate has been manipulated in the past and that it is frequently based on so-called “expert judgment” versus actual market transactions. Several banks have previously requested to withdraw as contributors, citing costs and potential legal or regulatory risk.

As eloquently pointed out by Andrew Bailey, at this time the market for unsecured funding among banks is less than robust. In its current role, the FCA has the power to require banks to provide submissions for the determination of Libor, although that power will likely expire shortly as a result of the European Union’s (EU) regulation of benchmarks.1

All things considered it is reasonable for investors to be concerned that banks might cease to voluntarily report Libor unexpectedly in the future. However, given the considerable scope of Libor and its characteristic as a public good, we expect that banks will voluntarily administer the benchmark until an alternative is firmly in place and do so even though they will no longer be compelled by the FCA. Libor administrator ICE could simply continue to calculate and publish Libor based on the rate quotes provided voluntarily.

Still, the industry has focused some efforts on establishing fallback provisions if Libor were to cease to exist, either because banks discontinue reporting or in the absence of sufficient time to carry out a transition.

Status of alternatives

Beyond concerns about an abrupt cessation of Libor or the inquiry into Libor-setting practices during past crises, regulators and the industry have been actively working on reform, and careful consideration has been made for both a replacement and the continuation of the existing benchmark. Public-private working groups in various jurisdictions have engaged to identify replacement benchmarks and are working on establishing a blueprint for a full transition.

In the UK, Switzerland, Japan and U.S., alternatives to Libor have been proposed that are based on actual transactions, thus seeking to address the most troubling aspect of how the current Libor benchmark is set. Further consideration has been given to the appropriateness of a “risk-free rate” based on a secured (repo) or an unsecured overnight rate. The existing Libor specification aligned the rate a bank earned on lending with the rate paid for overnight funding via wholesale unsecured lending markets.

However, banks have become less reliant on overnight funding as they have termed out their debt in order to comply with enhanced regulatory requirements on bank capital and liquidity management. In some jurisdictions, such as the UK and Japan, the chosen replacement rate represents an unsecured overnight risk-free rate that is already commonly used as the reference rate on collateral and as the discount rate for swaps. In the U.S., for example, the Alternative Reference Rates Committee (ARRC)2 selected the broad Treasuries repo rate as its proposed alternative benchmark.

With alternatives to Libor selected in certain markets, the focus has now moved to how to best ensure a fair and orderly transition. That transition must provide ample time for the market to react and for sufficient liquidity to be established in the new benchmark. Further, consideration must be given to any documentation changes required to reference the new benchmark and how the benchmark may apply to new trades versus existing trades. If existing trades continue to reference the old Libor, there is a risk that a bifurcated market will develop which may severely affect end-users and result in punitive impacts to valuations. PIMCO believes that because such a transition would be so complex and potentially involve significant participation within the financial industry to implement, the transition may require a regulatory mandate to ensure a coordinated and smooth move away from Libor and to the new benchmark.

By issuing a defined date for the FCA support of Libor to expire, regulators are encouraging the market to move forward with transition plans. It would be reasonable to expect that liquidity would likewise expand in the alternative benchmarks as the market coalesces around the accepted reference index and transition plans are developed. PIMCO has been an active participant in regulatory and industry working groups, including the ARRC, and will continue to participate by providing input and discussing the details with our clients and end-users in pursuit of an equitable transition process.

The risks

Our greatest concern is that a transition that is not well-scripted and fails to consider the potential impacts on all securities types threatens to favor certain market participants over others.

Forcing a Libor transition date before the market is prepared will likely cause a mass scramble to migrate positions, which will impose a cost to investors (through the bid/ask charged to hedge the basis). Those derivatives or Libor-linked transactions that are not transitioned to the new benchmark may become less liquid going forward or risk valuation changes due to variations in the fallback provisions. Derivative contracts or Libor-linked futures and securities may not have existing fallback language and may result in hedge or accounting issues for retail and small institution end-users.

Many of these transactions are traded by sophisticated investors who will most likely have the opportunity to adjust their positions prior to the phase-out date. However, other transactions may not be managed in the same way or may have tax, trust, legal and other considerations that limit their adaptability. These positions may become subject to contractual frustration, leading to disagreements between parties, making what is meant to be a smooth transition into one of much confusion and market disruption.

Our recommendation

PIMCO is supportive of market initiatives to enhance Libor to reference actual transactions instead of depending on voluntary submission from banks based on their “expert judgment.” However, the risks of potentially harming investors are too great to force a transition without a thorough review of the scope of products and investors affected by Libor.

A regulatory mandate may be required to administer Libor changes, but that action should only be taken after (1) there is sufficient liquidity in the alternative benchmark, (2) a full term structure exists in the alternative benchmark to assess the valuation impact to existing trades, (3) investors are provided sufficient time to adjust contracts as necessary and evaluate hedge or valuation ramifications and (4) the path for remaining contracts is sufficiently defined to ensure that those contracts that do not migrate do not wind up in a potentially worse place due to legal uncertainty.

1 The EU Benchmarks Regulation on indexes used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds went into force on 30 June 2016, and most of the provisions will apply from 1 January 2018. It will introduce a common framework and consistent approach to benchmark regulation across the EU. It aims to ensure benchmarks are robust and reliable, and to minimize conflicts of interest in benchmark-setting processes.2 The Financial Stability Oversight Council (FSOC) recommended in its 2014 Annual Report that U.S. regulators cooperate with foreign regulators, international bodies, and market participants to promptly identify alternative interest rate benchmarks. In response to the FSOC's recommendations and the objectives of the FSB, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) on 17 November 2014 in a meeting with representatives of major over-the-counter (OTC) derivatives market participants and their domestic and international supervisors and central banks. The ARRC was convened to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards such as the IOSCO Principles for Financial Benchmarks and to identify an adoption plan with means to facilitate the acceptance and use of these alternative reference rates. The ARRC was also asked to consider the best practices related to robust contract design that ensure that contracts are resilient to the possible cessation or material alteration of an existing benchmark or new benchmarks.

Summary

Banks have voluntarily agreed to sustain Libor (London Interbank Offered Rate) until the end of 2021, but plans are not yet concrete for an alternative benchmark.

Given the considerable use of Libor in determining interest payments for securities and derivatives globally, we expect banks will voluntarily administer the benchmark until an alternative is firmly in place.

It is possible, however, that at some point in the future banks elect not to continue reporting Libor. Regulators and industry participants should be prepared for all plausible scenarios.

PIMCO believes that a transition to another benchmark should be carefully managed and occur only when critical elements are in place, including sufficient liquidity in the alternative. Our greatest concern is that a transition that is not well-scripted threatens to favor certain market participants over others.

Disclosures

The "risk-free rate” can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.